Just in time for your barbecue on the 4th, the Office of Management and Budget released a 44-page response to critics of the White House’s handling of the Social Cost of Carbon. In this first of perhaps several posts at IER, I explain the deal with discount rates. An excerpt:

Present dollars are more important than future dollars. If you have to suffer damage worth (say) $10,000, you will be relieved to learn that it will hit you in 20 years, rather than tomorrow. This preference isn’t simply a psychological one of wanting to defer pain. No: Because market interest rates are positive, it is cheaper for you to deal with a $10,000 damage that won’t hit for 20 years. That’s because you can set aside a smaller sum today and invest it (perhaps in safe bonds), so that the value of your side fund will grow to $10,000 in 20 years’ time.

In this framework, it is easy to see how crucial the interest rate is, on those safe bonds. If your side fund grows at 7% per year, then you need to set aside about $2,584 today in order to have $10,000 in 20 years. But if the interest rate is only 3%, then you need to put aside $5,537 today in order to have $10,000 to pay for the damage in 20 years.

An equivalent way of stating these facts is to say that the present-discounted value of the looming $10,000 in damages (which won’t hit for 20 years) is $2,584 using a 7% discount rate, but $5,537 using a 3% discount rate. The underlying assumption about the size and timing of the damage is the same—the only thing we changed is the discount rate used in our assessment of it.

13 Responses to “OMB’s Whitewash on the Social Cost of Carbon”

Since pretty much no one thinks the appropriate discount rate for SCC is 7% this is something of a diversion. Maybe they should include the 7%, or maybe they should have had different regulations, but that does not affect the estimate of SCC that we should be using.

The pure rate of time preference has little meaning for generations not yet born. The consequence is that this aspect of discounting is generally lower than for short term (intragenerational) discounting. Stern controversially used very low value for this element of the Ramsey formula so got an average of about 1.5%. Whilst this is on the low side, I think economists generally accept that discount rates for inter generational effects should be lower than short term discounting. At present that would be well under 7%. I have asked here what people would consider an approriate rate, but have received no answer so far.

Why would long term discount rates be lower than short term, especially with how low rates are currently?

If you used the rates used to discount pension annuities to lump sum payouts, short term (24 months) would be 1.4%. Long term (20 yrs out) would be close to 5 %. So 7% does not seem high for Inter generational.

This paper discusses how USA could deal with this discount rate issue. As Bob says, it is as much a philosophical as economic issue. There is lots of discussion about social welfare and intergenerational utility maximisation, so lots of people here won’t like it much. The panel appears to have excellent credentials -the lead author is Kenneth J Arrow and the panel includes Nordhaus and Tol.

What are truly arbitrary are the costs and benefits themselves. How anyone has enough hubris to estimate any economic variable 300 years into the future is completely beyond me. The discount rate just doesn’t matter when you’re effectively taking 1,000 yard sniper shots in the dark.

” How anyone has enough hubris to estimate any economic variable 300 years into the future is completely beyond me.”

The trouble is, we can predict with almost certainty that there will be consequences. If we throw up our hands and say we cannot accuatey evaluate them so we must ignore them, then we are effectively valuing them at zero.

In the US and many other countries, most investments in reducing CO2 emissions are made by private companies. Those companies – through PUCs – are charging their customers a high rate on invested capital. That rate – not the artificially low rate used by the EPA – reflects the true cost of avoiding future emissions. The internal rate of return on invested capital and risk are what determines how much capital is invested in reducing emissions.

I can create an immediate paper profit by borrowing money at a low rate of interest, investing it in assets expected to create a cash flow with a high internal rate of return and then “marking my investment to market”. That is what Enron did. That turned out to be fraud. IMO, it is equally fraudulent to apply a low discount rate to the cost of future damage from CO2, when a much higher rate is being applied to investments in reducing emissions.

When the government is making the bulk of the investment, it would be fair to apply a low discount rate that reflect the government’s cost of borrowing. Unfortunately, that process can be highly inefficient, so the cost of emissions reduction will be higher. See Solyndra, subsidies to the rich for roof-top solar (the most expensive renewable energy), etc. In general, most developed societies recognize that the private sector allocates capital better than the government, even though they charge a higher rate. So, if you want the benefits of management by private investors, you are stuck with their discount rate.